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The Earned Income Tax Credit: Super-Powerful, but Underused

The Earned Income Tax Credit is a lifesaver for many. Source: Jeeves Miguel, Flickr.

Good intentions don't always produce desired effects. Consider, for example, the Earned Income Tax Credit (EITC). It was created decades ago as a way to help low-income workers who were paying more in Social Security taxes than many could afford -- but, sadly, it's underused.

The Earned Income Tax Credit is something that both Democrats and Republicans have agreed is important, with Ronald Reagan calling it a "sweeping victory for fairness" and "perhaps the biggest antipoverty program in our history." The folks at the Tax Policy Center have studied the Earned Income Tax Credit and note that, "After the Supplemental Nutritional Assistance Program (SNAP), the EITC is the largest cash or near cash assistance program targeted at low-income families. TPC estimates that more than 26 million households will receive a total of $60 billion in reduced taxes and refunds in 2015." The Center on Budget and Policy Priorities (CBPP) has noted that the Earned Income Tax Credit has effectively increased the ability of lower-income folks to work, reduced poverty, and reduced the use of welfare.

Let's review what it is and two key problems with it.

It's a powerful benefit for the poorFirst off, remember the distinction between tax deductions and tax credits. If you have a $1,000 tax deduction and you're in the 25% tax bracket, you'll get to remove $1,000 from your taxable income, avoiding $250 in taxes. A $1,000 tax credit, though, reduces your tax bill dollar for dollar, by $1,000. Credits are more powerful than deductions. Better still, the Earned Income Tax Credit is a refundable credit. With a typical credit, if you owe $700 in taxes and you have a $1,000 tax credit, you'll owe nothing, and that's that. With a refundable $1,000 credit, you'd get a $300 refund.

For 2014, the Earned Income Tax Credit offers a credit of up to $3,305 for qualified taxpayers filing jointly with one child; $5,460 for two children; $6,143 for three or more children; and $496 for no children. These are hefty sums, particularly for those with low incomes. For some folks, the credit can result in them owing no tax at all, or getting a refund.

The credit is based on your earned income and how many qualifying children are in your household. For 2014, if you earn $52,427 or more, you're out of luck. The IRS offers more qualification criteria and information on limits at its website. The office of the National Taxpayer Advocate offers details, also, such as noting that there are special rules for those in the military, members of the clergy, those receiving disability benefits, and those affected by disasters.

It's underusedNow that you understand how powerful of a tax aid the Earned Income Tax Credit is, you can more fully appreciate how unfortunate it is that it's woefully underused. That's partly because many don't know about it, and partly because it's more complicated than typical credits or deductions.

It's estimated that about one in five Americans qualify for the credit, but also that about 20% of those fail to claim it. That amounts to millions of people losing out on many millions of dollars in aid.

Part of the problem is that it's a fairly complex credit to deal with, due to many rules and restrictions. Thus, many folks who claim it need to pay for tax-preparation assistance, which robs the credit of some of its utility. (The Tax Policy Center says that about two-thirds of low-income parents seek assistance.) The IRS offers help for these taxpayers via its Earned Income Tax Credit Assistant, but not everyone knows about or uses that.

It's mis-used, tooThe complexity of the Earned Income Tax Credit has led to other issues, too, such as overpayment. Per the Tax Policy Center, "In 2011, the GAO [Government Accountability Office] reported that about $17 billion EITC claims were paid out in error in tax year 2010. The reasons for the high level of improper payment included high turnover of eligibility, confusion among eligible claimants, and the complexity of the law."

The CBPP has suggested some ways to improve the current situation, such as simplifying some of the rules related to the credit and beefing up funding for the IRS so that it can better enforce compliance and oversee commercial tax preparers, who generate many of the errors.

Author

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter... Follow @SelenaMaranjian